Powell May Sound Hawkish, But The Fed Is Actually Telling Investors To Buckle Up

by: The Fortune Teller

In the background of August's tepid employment report, two Fed branches have downgraded their growth Q3 forecasts to just 1.5%.

At the same time, the Fed's model, which is based on the yield curve, shows the probability of a recession rising to a new high.

Chairman Jerome Powell may try to sound particularly hawkish, but most other indicators show the economy is slowing down.

Laugh as much as you want, but know you may end up laughing at your own expense, mistakes, or risk.

Let's start with the good news: The party isn't over yet.

We now count 107 consecutive months of payroll growth. This is, by far, the longest streak over the past 8 decades (since 1939).

Here are the longest positive streaks in non-farm payrolls, since WWII:

Source: Charlie Bilello, @charliebilello

In-spite of Powell's hawkish tone during a speech in Switzerland last Friday, a 25 bps rate cut on the next FOMC meeting (September 18th) seems like a certainty.

The Fed is going to deliver the goods, because such a firm market expectation - a probability of 91.2% for a 25 bps cut - isn't going to be answered with a disappointment.

Source: CME Group

Nonetheless, aside of the market very much anticipating for - therefore, getting - a rate cut, it should be noted that the job market seems like it has already peaked.

Furthermore, while Powell is trying (too hard?) to deliver a "business as usual" type of message, various models used by the Fed (branches) are clearly indicating that the circa 3% GDP growth we've experienced over the past 2-3 years is no longer probable.

In the background to the tepid employment report released last Friday, the Federal Reserve Bank of New York (the "New York Fed") is updating its GDP forecast for the third quarter from 1.8% to only 1.5%. At the same time, the forecast for the last quarter of 2019 is falling to just 1.1%.

Source: Federal reserve Bank of New York

A growth rate of only 1.3% (on average) for the remaining two quarters of 2019 is not a precedent (we had a 1.1% pace of growth in Q4/2018), but it's certainly way below the norm, as the below chart shows.

Since Donald Trump won the US elections, back in early November 2016, US GDP growth has been averaging closer to 3% than to 2%. Moreover, half the quarters over the past two years have seen growth rates greater than 3%.

So not only a drop to 1.3% is more than halving the pace that the American economy got used to, but (if the New York Fed's forecast is accurate) it's also going to be the first time that we get two consecutive quarters with such low growth.

Taking into consideration that we are approaching an elections year, it's no wonder that president Trump is all over Twitter looking for the Fed to act as fast and furious as possible.

Thing is, the New York Fed isn't alone in forecasting much slower growth.

Last Tuesday, September 3 -- three days before the New York Fed came up with its own downgraded forecast -- it was the Federal Reserve Bank of Atlanta updating its third-quarter GDP growth forecast to just 1.5%, down from a previous forecast for a 1.7% growth (and coincidentally, or not, exactly what the New York Fed is now forecasting too) .

Source: Federal Reserve Bank of Atlanta

We now have two distinguished Federal Reserve offices telling us that the US economy is slowing down significantly. Still, that's not the end of it.

The Fed's monthly update to its very own "recession model", which measures the probability of a recession over the next 12 months, is also signaling that danger lies ahead.

The model, which is based on US government bond (TLT, IEF, GOVT, SCHR, VGIT, TIP, SHV, SHY) yields for a 3-month and 10-year periods, points at a 37.92% probability (in absolute, non-adjusted, terms) for a recession to hit the US over the next 12 months. That's the highest level the model has produced since 2008!

If the data is being normalized/adjusted - and it should - we are looking at an annualized probability of 49%!

The Fed model, which is based on US bond yields for a 3-month and 10-year periods, now has a probability of about 49%!

The funny thing is that despite the weak non-farm payroll numbers and lower growth forecasts, the Fed chairman was using a particularly hawkish in his speech last Friday (September 6th), during a conference held by the Central Bank of Switzerland (EWL).

In his speech, Powell argued that the US economy is in a good position and keep performing well. He added that the Fed still expects moderate growth and continued strength in the job market.

I presume that having very little ammo to fight a slowdown with is putting Powell is a very unpleasant, ever scary, position. Should the US economy enters a recession in the foreseeable future, the Fed will have very little room to maneuver.

As a matter of fact, the next recession - regardless of its exact timing - is going to be the most challenging, monetary wise, than any other recession over the past 60 years!

Source: Lawrence H. Summers, @LHSummers

Powell is likely using hawkish language on purpose, knowing that there's a lot of psychology involved in how investors react to the perceived (not necessarily real) state of the the economy.

Just like an inverted yield curve, talking about a recession is, in and of itself itself, enough to encourage a recession. If you keep repeating the same mantra, it might become true, even if in the moment it's not. This is called the Pygmalion effect. Perhaps it's no coincidence that the "Powell Put", "Psychology", "Policy", "Perception", and "Pygmalion" all start with P.

Nonetheless, in spite of this grand plan, investors are worried. As you can see in the below chart, many people are already talking (or at least searching for data) about the forbidden word: Recession.

Powell chooses, at least for now, to laugh at the risk of a recession, however we believe that this is a deliberate, tactical, move, not a genuine reflection of what he truly has in mind. Let's not forget that the Fed has a history of "laughing" all the way to a recession, until there's nothing to laugh about.

Don't believe me? Look at the below chart, which is based on the Fed's verbatim transcripts of all FOMC meetings. It shows every instance the transcript denotes “laugh,” "laughing," or "laughter."

As the chart shows, the Fed was laughing all the way into the subprime crisis. Only when the crisis hit hard in 2008 and things got serious, the laughs stopped.

Source: Jim Bianco, @biancoresearch

The last thing we should be doing right now is laughing. Things are way too concerning for anyone to laugh about. You may laugh at your own risk, but the stakes are currently very high.

If the growth rate is indeed moving down, closer to the 1% mark, there's very little margin of safety left, if any. That's true not only for the Fed's monetary policy, but for investors as well.

It's hard to claim that investors are being sufficiently compensated for the risk they are taking on. Over the past four months (roughly), the main indices (SPY, DIA, QQQ, IWM) have been mostly trading flat:


At the same time, the implied volatility of the broad market (SPY) is close to the levels we witnessed in February 2018 and again in December 2018.

Higher risk is calling for either much higher returns (that we don't see at the moment), and/or a more defensive approach.


Retrospectively, this might turn out to be just another false alarm - one out of many we've seen over the past decade. However, it's not the end result that matters, but the adjustment of investment style to the level of risk.

Proper risk management dictates that when risk is higher (as it clearly is now), unless the potential return is elevated at least as much as the risk (and it clearly isn't) the investment approach should be much less aggressive than it was when the risk/reward outlook was more compelling. Trade accordingly.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.